A Great New Book on Behavioral Investing

Crosby provides many great examples that help us understand how and why we act against our self-interest – though much of the financial media and Wall Street are not far behind. The following, from a study by John Coates, a former trader turned neurologist, provides great insights about the time-varying nature of how we deal with risk as well as why. In a June 7, 2014, New York Times article, “The Biology of Risk”, Coates explained: “Most of us tend to believe that stress is largely a psychological phenomenon, a state of being upset because something nasty happened. But if you want to understand stress you must disabuse yourself of that view. The stress response is largely physical: It is your body priming itself for impending movement.”

Crosby explained that “In moderation the cortisol produced by feelings of stress is sort of a wonder drug that increases physical arousal, improves memory, promotes learning, enhances pleasure seeking and increases motivation. But if stress persists over a longer period, say like that associated with most market downturns, the exact opposite occurs: Behavioral flexibility decreases, immunological systems are compromised, attention wanes, symptomatology emerges and learned helplessness replaces feelings of self-efficacy.”

To study the effect of persistent exposure to stress, Coates tested the cortisol levels of professional traders. He found that it took just eight days of elevated market volatility to cause cortisol levels to increase a whopping 68%! This led to an incredible 44% decline in the trader’s appetite for risk. Coates concluded that risk models that assume stable risk preferences are false (keep this in mind if you designed your investment plan during a period of calm markets). Coates explained: “Humans are designed with shifting risk preferences. They are an integral part of our response to stress, or challenge.”

Crosby noted that “Studies suggest we lose roughly 13% of our cognitive capacity under stress.” The responses of the professional traders help us understand why, when faced with the stress of a prolonged market decline, so many untrained individual investors engage in panic selling despite the historical record that every bear market has been followed by new record highs. Crosby explained: “As much as we may wish it otherwise, our bodies seem uniquely skilled at holding on to fear and letting it loose at just the inopportune time.” It’s why most financial advisors I have met tell me they spend more time managing people then they do managing money.

Knowing how we respond to stress is why it’s so important to know your investment history. As you can see in the following table, over the last 100 years the DJIA has experienced 15 drops of at least 20%, an average of about one every seven years, with an average loss of 38.7% and an average duration of 403 days.

Peak-to-Trough	Days	Maximum Drawdown
November 1919 – September 1921	455	-46.2%
October 1929 – July 1932	679	-86.3%
March 1937 – March 1938	272	-49.0%
November 1938 – April 1942	871	-41.2%
May 1946 – June 1949	767	-24.0%
December 1961 – July 1962	135	-27.1%
February 1966 – October 1966	168	-25.2%
December 1968 – May 1970	373	-35.9%
January 1973 – December 1974	483	-45.1%
September 1976 – February 1978	368	-26.9%
April 1981 – August 1982	328	-24.1%
August 1987 – October 1987	38	-36.1%
July 1990 – October 1990	61	-21.2%
January 2000 – October 2002	685	-37.8%
October 2007 – March 2009	355	-53.8%
October 2018 – Dec. 24, 2018	55	-16.3%
Average	403	-38.7%
Median	368	-36.1%

What makes such markets difficult to live through without panicking is that, on average, investors are highly risk averse. Richard Thaler, winner of the Nobel Memorial Prize in Economic Sciences and author of Misbehaving, found that we tend to feel the pain of a loss twice as much as we feel the joy from an equal-sized gain. That ratio, and our physical response, increases with the size of the investment.

The lesson is that, based on the historical record, a 65-year old couple with a planning horizon of 30 years needs to plan on living through four to five prolonged and severe bear markets. Therefore, their plans must anticipate them, and they must ensure that their asset allocation doesn’t take more risk than their stomachs can handle. Otherwise, the likely result will be panicked selling. As Adam Smith stated in his book The Money Game, “If you don’t know who you are, Wall Street is an expensive place to find out.”

Four consistent behavioral risks

In his research, Crosby found 117 behavioral biases. The book breaks them down into four major categories: ego, conservatism, attention and emotion.

Ego leads to problems such as confirmation bias, perhaps the strongest bias of them all. He notes that people love to be told what they already know and get uncomfortable when you tell them something new (such as a preference for dividends not being economically rational). He explains that it is human nature to try to confirm existing beliefs rather than ask why one might be wrong. This helps maintain our ego. Crosby provided many fascinating examples which demonstrate that when presented with new information that contradicts our preconceived beliefs: “Far from seamlessly assimilating new ideas into existing beliefs, research shows that we actually tend to get more firm in our cherished beliefs when those beliefs become challenged. … True or false, once an idea takes root it can be very hard to dislodge. … This tendency for beliefs to get even stronger in the face of contradictory evidence, known as the backfire effect, is even more pronounced when the information presented is ambiguous or unclear. … We are programmed to accept self-affirming truths at face value and to be deeply skeptical of anything that offends us.” One example of this tendency is that “Research on people critical of vaccinations shows that when presented with facts that disagree with their unscientific views, they actually become more entrenched in their wrong-headed position.”

Another related problem is overconfidence, an all-too-human trait. Crosby notes that “Overconfidence makes it hard for us to learn from new information and suggests we are prone to revise our beliefs only when it suits us.” He cited research that found most investors consistently overestimated both the future and past performance of their investments. Amazingly, fully one-third of those who believed they had outperformed the market had lagged it by at least 5%, and another quarter lagged by at least 15%! The researchers found: “The correlation coefficient between return estimates and realized returns was not distinguishable from zero.” In other words, our egos create alternative universes to protect us from feeling bad. Demonstrating how bad the problem was, only 30 percent of investors surveyed judged themselves to be average, and the average overestimation of their returns was 11.5% a year. Crosby concluded: “Overconfidence simply made it impossible for them to accurately recall and report how they did.” Crosby also noted that overconfidence leads to being undiversified (taking excessive uncompensated risks), as diversification is only needed by those who don’t know the future.

Crosby also cautioned investors against following Peter Lynch’s famous advice to “buy what you know,” stating this is profoundly dumb advice (with which I agree). Doing so can lead to confusing the familiar with the safe, as well as undiversified portfolios. It also makes the mistake of confusing information with value relevant information.

Conservatism

Among the many mistakes in this category are those related to the endowment effect – the tendency to overvalue what we already own and undervalue what we don’t. “Even professional traders exhibit the tendency to not sell investments they already hold, even though in many cases they admit they would not buy the holding in question today if asked to start afresh.” This relates to the fallacy of the sunk cost. Crosby explained: “The more time and attention we give a decision, the more warped our sense of what is right may become.” This means that, Crosby added, “The larger the past resource invested in a decision, the greater the inclination to continue the commitment in subsequent decisions.”

Crosby also focused attention on the issue of loss aversion and how the media plays to our fears – there’s a reason “if it bleeds it leads” is a cliché. The media know that scary stories bypass some of our critical filters and have enormous staying power for evolutionary reasons. Pay careful attention to Crosby’s advice: “We live in a time when information is more available than ever, but the availability of information says nothing about its usefulness. … Keeping your head in an information age designed to help you lose it is the never-ending task of the behavioral investor. Cultivating principled contrarianism, and understanding of behavior and a familiarity with enduring empirical principles of finance may not come naturally, but they are the keys to weeding out disinformation en route to mastery of self and wealth.”

Emotion

Crosby quotes psychologist and trading coach Brett Steenbarger: “The net effect of emotion on trading appears to be a disruption of rule governance. … Under emotional conditions…their attention became self-focused to the point where they were no longer attentive to their rules. Often it wasn’t so much a case that under emotional conditions they doubted their rules; rather, they simply forgot them.” Crosby added: “No matter how smart, an emotional investor is a stranger to himself and his rules.” And one reason is that emotions have an impact on how we assess probability. Crosby continued: “Predictably, positive emotion leads us to overstate the likelihood of positive occurrences and negative emotion does just the opposite. This coloring of probability leads us to misapprehend risk.”

Perhaps the most fascinating of all research studies presented was a Stanford University study, “Investment Behavior and the Negative Side of Emotion,” which examined the question: If inhibiting emotion is good, is it possible that doing away with it altogether is even better? The researchers pitted 15 individuals with brain damage to their emotional processing centers against 15 “neurotypical” peers in a gambling task. The brain-damaged participants handily outperformed, being more willing to take larger bets and bouncing back more quickly from setbacks. The neurotypical participants became particularly risk averse after periods of setback.

Summary

Crosby offered the following recommendations to help make you a better advisor:

• Systematic investing trumps discretion.
• Diversification and conviction can coexist.
• Prepare for bursting bubbles without being too fine-tuned to them.
• Less is more when it comes to information.

He added: “Understanding that markets are part luck and part skill informs us that we should emphasize rules over practice and that we should hold portfolios that are diverse enough to protect against bad luck but differentiated enough to benefit from tilting profitability in our favor in a rules-based manner.”

A great summary of the takeaways from Crosby’s book is this quote from investment manager James O’Shaughnessy, author of What Works on Wall Street: “The key to successful investing is to recognize that we are just as susceptible to crippling behavioral biases as the next person.” Crosby added: “Exceptional investment outcomes are attainable by all of us, if we just stop trying so hard.” The key, as Nassim Nicholas Taleb stated, is to understand that “Even once we are aware of our biases, we must recognize that knowledge does not equal behavior. The solution lies in designing and adopting an investment process that is at least partially robust to behavioral decision-making errors.” Crosby then added these words of wisdom: “Becoming a behavioral investor is fundamentally about scraping away all of the bad lessons and fallacious visions that you’ve been sold and realizing that doing less gets you more.”

To improve the odds of avoiding behavioral errors and increase the odds of achieving your goals, read Crosby’s book and the baker’s dozen from my list. And finally, 25 years of experience as an advisor has taught me that the way to give yourself the best chance of avoiding behavioral errors is to have a well-thought-out plan, a written and signed investment policy statement that defines your ability, willingness and need to take risk, and acknowledges the history of financial market returns and the evidence on the virtual inevitability of bear markets. It’s not a guarantee that having such a plan will prevent you from panic selling during the next bear market, but it will improve the odds of your doing so.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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